ADP: High-Quality Company Enjoying Low Unemployment
Most employees in the U.S. likely know the ADP brand name as it likely shows up on their paycheck every two weeks. Although the payroll services market is still highly fragmented, the largest in that industry, Automatic Data Processing Inc. (NASDAQ:ADP), still has the largest market share at approximately 11%.
The company provides cloud-based human capital management solutions around on a global basis. It operates in two segments, Employer Services and Professional Employer Organization. The Employer Services segment offers payroll, benefits administration, talent management, HR management, workforce management, insurance, retirement and compliance services. The PEO Services segment provides HR outsourcing solutions to small and mid-sized businesses through a co-employment model and offers benefits packages, protection and compliance, talent engagement, expertise, comprehensive outsourcing and recruitment process outsourcing services.
Payroll services are currently delivered to 40 million workers globally, which include 25 million in the U.S. and 15 million internationally. The company also partners with approximately 8,000 tax agencies in the U.S. ADP moved $2.7 trillion in payroll and taxes on behalf of clients and their employees in fiscal year 2022. Currently, the company operates in 140 countries and has over 1 million clients.
Founded in 1949, the company currently has a market capitalization of $89 billion.
Financial review
In January, the company reported its second-quarter financial results for the period ending Dec. 31, 2022. Revenue increased 9% (10% organic and constant currency) to $4.4 billion. Sales for PEO services grew 13% and Employer Services increased 10% organically. Operating income gained 15% to $1.1 billion and the operating margin increased to 24.3%. Earnings per share grew 18% to $1.95 compared to $1.65 in the prior-year period.
Automatic Data Processing typically holds billions in float, or wages in transit from its employer-related services. As of Dec. 31, those amounts totaled $40.8 billion. The company earns interest on that float and is the beneficiary of a rising rate environment. Interest earned increased 77% to $187 million during the quarter. Substantially all of these funds are invested in investment-grade securities.
ADP generates significant amounts of free cash flow and maintains a balanced and disciplined approach to capital allocation. Organic reinvestment is a key strategy and, in the 2022 fiscal year, the company spent $1.2 billion in systems development and programming. Targeted acquisitions is another important aspect and in recent years, the company spent $615 million to acquire Global Cash Card and Workmarket and spent $120 million to buy Celergo. Returning cash to shareholders has also been a long-time focus and the company has a 48-year track record of increasing dividends. The company has also been a routine purchaser of its own shares, having reduced the share count by approximately 1% annually over the past 10 years.
Valuation
Consensus earnings per share estimates for the fiscal year ending June 30, 2023 is $8.12 and $9.01 for the following year. That puts ADP selling at 26 times earnings and with an enterprise value/Ebitda ratio of 18. That is roughly in line with major competitor Paychex Inc. (NASDAQ:PAYX). The price-earnings ratio is also close to the high end of recent trading ranges.
The GuruFocus discounted cash flow creates a value of only $134 per share when using $8.12 in earnings as the starting point and a long-term growth rate of 8%.
The average price target by Wall Street analysts is $248 with a high of $278 and a low of $211.
The company currently pays a dividend of $5 on an annualized basis, which equates to a 2.31% dividend yield.
Guru trades
Gurus who have purchased shares of Automatic Data Processing recently include Paul Tudor Jones (Trades, Portfolio) and Joel Greenblatt (Trades, Portfolio). Investors who have reduced or sold out of their positions include Jim Simons (Trades, Portfolio)' Renaissance Technologies and Ray Dalio (Trades, Portfolio)'s Bridgewater Associates.
Summary
The fortunes of ADP and other employee-related service companies are typically tied to the overall economy, in particular the levels of unemployment. During the brief Covid-19 recession and high levels of unemployment, ADP's stock dropped over 40% from its highs. Nonetheless, the company successfully managed its operations during this time and has raised its dividend almost every year.
A stronger economy or maintaining current levels will continue to benefit the company if it is to avoid the cyclical swings in private sector employment. ADP has always been thought of as a well managed, high-quality company and often attracts investor interest throughout most economic cycles.
In periods of high unemployment, the stock often becomes attractive as many investors focus on the long term and ignore short-term swings in the economy. We are not at those levels now as U.S. unemployment is still remarkably low at 3.5%. When the large-scale tech layoffs become recognized and a recessionary environment occurs, it is possible the unemployment rate will skyrocket and have a negative affect on ADPs earnings.
Investors may be better off waiting for bad times before investing in ADP and hold until the good times return, as they always do.
This article first appeared on GuruFocus.
